The SEC’s Appointment Problem and Its Likely Solution

With the passage of Section 929P(a) of the Dodd-Frank Act in 2010, the SEC saw the largest expansion of its administrative enforcement power to date. Prior to that, SEC administrative proceedings were limited to obtaining an order enjoining violations of the Exchange Act. Section 929P(a) amended this, authorizing the SEC to seek civil monetary penalties from “any person” in an administrative hearing.

While the SEC still brings a majority of its cases in federal courts—roughly 63 percent this fiscal year through June—a growing proportion of cases have been tried in its internal administrative tribunals, a trend the agency intends to continue. These internal proceedings are presided over by Administrative Law Judges (“ALJs”), whom the SEC describes as “independent judicial officers … [imbued with the power to] issue subpoenas, conduct prehearing conferences, issue defaults, and rule on motions and the admissibility of evidence.”

Expansion of internal administrative proceedings, however, has hit a snag; myriad challenges have been brought contesting the constitutionality of the ALJs’ appointments. Former Standard & Poor executive, Barbara Duka, for example, has brought a challenge in the U.S. District Court for the Southern District of New York, alleging “that the ALJs’ appointments violate the Appointments Clause because the ALJs, as ‘inferior officers’ under Article II, may only so preside on due and proper appointment by a constitutional Officer, here, the [SEC] Commission[,]” which has not occurred. In other words, the allegations suggest that the ALJs are inferior officers, rather than employees, and thus must be appointed under Article II. Ms. Duka’s challenge is likely to result in a favorable ruling, as Judge Richard Berman issued a preliminary injunction, as Ms. Duka had “demonstrated irreparable harm along with a substantial likelihood of success on the merits of her claim ….”

“The line between ‘mere’ employees and inferior officers is anything but bright.” The Supreme Court in Freytag, the seminal Appointment Clause case, articulated a definitional standard for inferior officers, predicated on “significant authority pursuant to the laws of the United States.” The Freytag court concluded that Tax Court judges meet this “significant authority” standard, as their duties include taking testimony, conducting trials, ruling on the admissibility of evidence, and enforcing compliance with discovery orders.

At no point has the SEC seriously suggested that the ALJs are appointed by the Commission itself, as would be required under Article II. Rather, the SEC has maintained that ALJs are not inferior officers but employees, and thus not governed by the Appointments Clause. The SEC’s argument is predicated on an interpretation of Freytag that views “the authority to issue final rulings” as a necessary component of the “significant authority” standard—an authority SEC ALJs do not possess. This interpretation of Freytag has, thus far, not been persuasive. In Duka v. SEC, Judge Berman stated, “the SEC ALJs are ‘inferior officers’ because they exercise ‘significant authority pursuant to the laws of the United States.’” Furthermore, in the Freytag opinion itself, the Supreme Court noted that the authority to issue final decisions was not a necessary component of inferior officers as “this argument ignores the significance of the duties and discretion that special trial judges possess.”

Whether a “quick fix” is possible has not been articulated by the SEC. Judge May queried whether such a solution existed during a judicial conference, to which the government responded that “the Commission should not act precipitously to modify its ALJ scheme.” In the event that ALJs are determined to be inferior officers, which appears likely, the SEC would need to deviate from the status quo. Although the Commission has ducked the question when posed directly, there does not appear to be any great hurdle standing in the way of meeting the Appointments Clause. Indeed, the FTC, facing a similar challenge to an ALJ proceeding, ratified the appointment of the in-house judge “to ward off any possible claim that [the] administrative proceeding violates the Appointment Clause.” Nothing suggests that the SEC is incapable of a similar prophylactic measure.

Fortunately for the SEC, it seems improbable courts would willingly apply such a ruling retroactively given the administrative impracticalities of vacating all past proceedings. Rather, the ruling is likely to be applied prospectively—according past proceedings de facto validity—and stayed to allow the SEC to implement remedial measures, i.e., ratifying the ALJs’ appointments. Far from a novel solution, this would be akin to the approach taken by the Supreme Court after bankruptcy courts were ruled unconstitutional in Northern Pipeline Construction Co. v. Marathon Pipe Line Co. The court noted that, “Th[e] limited stay w[ould] afford Congress an opportunity to reconstitute the bankruptcy courts … without impairing the interim administration of the bankruptcy laws.” Other examples of prospective rulings intended to cure the impracticality of vacating past actions include: Buckley v. Valeo, Chicot Cty. Drainage Dist. v. Baxter State Bank, and Ins. Corp. of Ir. v. Compagnie des Bauxites de Guinee.

Although it appears likely that the appointment of ALJs will be deemed to violate the Appointments Clause, the practical impact would be limited given a prospective ruling. Assuming the SEC adheres to the appointment requirement moving forward by ratifying its ALJs, the administrative proceedings can continue unimpeded. Indeed, the SEC may even undertake ratification without announcement to save face, although it may be well advised not to do so given the public exposure of this issue.

The preceding post was originally published on October 21, 2015 by the Columbia Business Law Review, and is available here.